Fed Chair Jerome Powell's semi-annual Monetary Policy Report to Congress, delivered to the Senate Banking Committee this morning, put paid to any notion that the Fed thinks it is nearing the end of the current tightening cycle. Market expectations are growing that the next rate move might be another 50 basis points. The recent switch away from expectations of a "pivot" has been remarkable to behold, given that most measures of inflation seem to be heading lower.
The first full paragraph of Powell's testimony basically spells out his full message:
My colleagues and I are acutely aware that high inflation is causing significant hardship, and we are strongly committed to returning inflation to our 2 percent goal. Over the past year, we have taken forceful actions to tighten the stance of monetary policy. We have covered a lot of ground, and the full effects of our tightening so far are yet to be felt. Even so, we have more work to do. Our policy actions are guided by our dual mandate to promote maximum employment and stable prices. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of labor market conditions that benefit all.
That last sentence is worth contemplating. It seems as if Powell is saying that the Fed needs to increase unemployment in order to achieve a healthy employment market. It's reminiscent of the famous statement by a US military officer in 1968, after the devastation of the Vietnamese town of Ben Tre: "It became necessary to destroy the town in order to save it". This tick-tock of the question period following Powell's opening remarks, indicates that Senators, led by Elizabeth Warren, were largely unimpressed.
It is disappointing, if not entirely surprising, that the Fed is showing no sign of rethinking its policy approach. The statement that "the full effects of our tightening so far are yet to be felt" is part of the its now-standard acknowledgement that monetary policy operates with considerable lags. Yet it should be recalled that CPI inflation peaked in June 2022, mere months after the start of the current tightening cycle. Does this mean the lags are not as long as the Fed thinks, or does it mean -- perish the thought -- that the decline in inflation over the past six months and more is not actually the result of the Fed's actions at all?
The Fed's approach is largely based on the notion that unemployment and inflation are inversely related -- the so-called Phillips curve concept, based on a sixty-year-old academic paper that even your aged blogger recalls reading as an undergrad. This approach might possibly work when inflation is being driven by wage pressures, but that in no way describes the current situation. As is widely acknowledged, even by the Fed, wages have been rising more slowly than prices throughout the recent cycle.
The Fed's response to this -- to quote Powell, "Although nominal wage gains have slowed somewhat in recent months, they remain above what is consistent with 2 percent inflation and current trends in productivity." has some validity. However, it begs the question of just how high rates (and unemployment) might have to go to achieve the desired effect on measured inflation, given that monetary policy is not attacking the root causes of current price pressures. The "dot plot" released after the next FOMC meeting on March 22 is likely to show an expectation that the funds target will peak at 5.5 percent or even higher, and stay at that level well into 2024 or even beyond.
By way of Canadian content, note that Powell's testimony came just a day before the Bank of Canada's rate decision, set for March 8. Markets are fully convinced that the Bank will keep rates on "conditional" hold this time. However, with the Fed sounding more hawkish by the day, there are concerns that the Bank will not be able to decouple its actions from those taken by the Fed for very long without adverse consequences, particularly for the exchange rate. The Bank's recent move to the sidelines was strongly influenced by a desire not to tank the heavily-indebted consumer sector. Governor Macklem and his colleagues will be hoping fervently that the Fed's bark turns out to be worse than its bite,
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